What it means
A reserve requirement is a rule that a bank must keep a stated fraction of its deposits in cash in its vault or as a balance at its regional Federal Reserve Bank. The requirement applies to a category called transaction accounts, such as cheque accounts, which customers can use to make payments.
The remaining deposits can be lent or invested. The ratio is set by the Federal Reserve Board and can differ by the size of the bank's deposit base, with smaller institutions facing lower ratios in the past.
The Board has also at times set the ratio at zero, in which case the requirement exists on paper but does not restrict lending. The ratio is a policy lever, though it is used far less actively than interest rates today.
Historically the rule also limited how often customers could make certain withdrawals or transfers from savings accounts each month. That limit was relaxed by the Federal Reserve, and banks now decide their own policy within the rules the Board allows.
Customers who remember the old six-per-month limit may still see it in account terms. The rule matters to finance people because of its link to liquidity and lending capacity.
If the required ratio rises, banks have less to lend per dollar of deposits and credit tends to tighten, while a fall lets banks lend more. Treasurers and analysts follow policy statements for hints about how conditions may change.
It is also worth knowing the difference between a reserve requirement and a capital requirement. Reserves are about liquidity on the asset side, meaning cash held against deposits.
Capital is about loss-absorbing funding on the other side of the balance sheet, meaning the owners' stake. In practice most banks hold more liquidity than the minimum, because they need cash for daily payments, customer withdrawals and unexpected stress.
The legal requirement is therefore only a floor, and a bank's own liquidity policy usually sits well above it. Analysts looking at a bank's health pay more attention to its liquidity buffers than to the regulatory minimum.
In practice
Real-world examples.
Example
A community bank with $200,000,000 of reservable deposits applies a 10% illustrative ratio and holds $20,000,000 at its regional Federal Reserve Bank. The treasurer checks the figure at the end of each reporting period.
Example
A bank analyst at an investment firm reads a Federal Reserve statement about a lower reserve ratio. She estimates how much additional lending capacity this might give banks and flags a likely uplift to bank earnings.
Example
A retail customer opens a savings account and asks whether a limit on withdrawals applies. The bank explains that its own account terms now decide this, following the Federal Reserve's relaxation of the old rule.
Formula
Calculation
Required reserves = reserve ratio x reservable deposits
Assume, purely for illustration, a reserve ratio of 10% and a bank with $500,000,000 of reservable transaction deposits. Required reserves = 10% x $500,000,000 = $50,000,000. The bank may lend or invest up to the remaining $450,000,000 of those deposits, subject to its other limits. If the ratio were cut to 8%, required reserves would fall to $40,000,000 and the bank would have $10,000,000 more room to lend.Case study
Seen in the real world.
Granite Ridge Bank is an illustrative, fictional institution with a large base of cheque account deposits. Its treasury team prepared for a scenario in which the Federal Reserve raised the reserve ratio from 8% to 12% on transaction deposits.
On $400,000,000 of such deposits, required reserves would rise from $32,000,000 to $48,000,000, an increase of $16,000,000 that would have to be held rather than lent. The treasury team arranged additional funding and trimmed its plan for new lending in advance. The illustrative lesson is that a change in the ratio, even a modest one, moves a meaningful amount of cash on a large deposit base.
Granite Ridge also reviewed which of its deposit products counted as transaction accounts. Moving some customers into longer-term products would change the reserve calculation, so the treasurer modelled the impact before approaching customers.
Watch out
Common mistakes.
- Believing that banks lend out only the money that customers deposit and nothing else, when lending also creates deposits and the reserve ratio is only one of several limits on growth.
- Confusing reserves with capital, when reserves are liquid assets held against deposits and capital is the owners' stake that absorbs losses.
- Assuming the ratio is always above zero, when the Federal Reserve has set it to zero in the past.
Questions
People also ask.
Which accounts are covered?
Generally the requirement applies to transaction accounts, such as cheque accounts, rather than to savings or longer-term time deposits, and the rule defines each category in detail.
Who sets the reserve ratio?
The Federal Reserve Board of Governors sets it within limits established by law.
Do reserves earn interest?
The Federal Reserve pays interest on balances that banks hold with it, at a rate it sets as a policy tool.
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